Leverage consequence on ROE

Leverage consequence on ROE:

Leverage means lifting a machine. In lifting machine, what do you observe? A person uplifts the weight with the assist of machine. Even uplifted weight might be 1000 times heavy than that person's own weight. However in this finance term, it is not lifting machine. However similar to lifting machine, we can employ leverage tool to uplift return on the equity level.

What is ROE?

It is the rate of return on equity share capital. It is as well termed as shareholder return. ROE can be seen with two methods. From company view point, this is return on his investment that company has to raise at any cost for surviving the business however from shareholder view point, it is dividend. ROE demonstrates the effectiveness of company. When company produced high ROE, it is excellent for company and its shareholders. ROE can be modified by modifying the leverage.

What are the sources of Leverage?

a) Taking fixed asset
b) Taking Loan
c) Taking Hedge fund

Leverage consequence on ROE:

When we talk the leverage consequence on ROE, it means, we talking operating leverage consequence, financial leverage consequence and combined leverage consequence on ROE.

A. Operating Leverage Effect: % Change of EBIT is greater than % Change in Sale

When percentage change of earnings prior to interest and tax is greater than percentage change in sale, this operating leverage will influence ROE positively since at this level, per unit fixed cost will reduce and small raise in sale will boost EBIT. When EBIT will rise, ROE will too raise. After dividing percentage change of EBIT with percentage changes in sales. We can get ratio of it and it points out, how EBIT will change when changes will be done in sales. 2:1 of operating leverage means when 100% sales will raise 200% EBIT will rise. As interest is fixed cost, therefore with this ROE will raise.

Case a: High Operating Leverage: Very high operating leverage is not good, it might be high risky.
Case b: Low Operating Leverage: This leverage might be helpful whenever sale market is changeable.

B. Operating Leverage Effect: % Change of EBIT is lower than % Change in Sale

Now observe second face when percentage changes of EBIT is lower than percentage changes in sales, this means 200% sale will raise, 100% EBIT will raise when operating leverage is 1:2. This condition is less efficient for improving ROE.

C. Consequence of Financial Leverage on ROE:

When we have to ensure real effect of leverage on ROE, we have to study the financial leverage. Financial leverage refers to the utilization of debt to get additional assets. Financial leverage might reduce or raise return on equity in various conditions.

Case i: High Financial Leverage: It means acquiring a huge debt by borrowing funds at least rate of interest and employing the excess funds in high risk investments in order to make the most of returns.

Case ii: Low Financial Leverage: It means acquiring a low debt by borrowing funds. It might affect positively, when reduce the value of bought asset with this small debt.

D. Consequence of High Operating leverage and High Financial Leverage:

This will rise ROE however it is very risky too.

E. Consequence of Low Operating leverage and High Financial Leverage:

This is optimum combination for carrying optimum return on equity.

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